Belief in a new paradigm of oil prices is misguided

And the lower prices fall, the more people are sure we have entered a ‘new paradigm’ of low oil prices.

This thinking is illogical. For all their imperfections, real or imagined, oil markets tend to behave roughly in accordance with the most basic economic laws. Low prices tend to spur demand and drive exploration and development budgets down, paving the way for prices eventually to recover.

That is what economists call a commodity cycle – and oil is just another commodity, after all.

In 1997-2003, production decisions by OPEC (the cartel of oil- producing governments) have made commodity cycles shorter and sharper, since the cartel tends to overshoot in both directions as it tries to adjust its output to the ‘call’ on its oil. And, in 2004, the global oil economy has gone through exceptional circumstances.

For the first time since the beginning of the oil industry some 14 decades ago, oil demand stretched available production capacity to the limit.

Add a ‘fear premium’ that some traders put near $10 per barrel and you get the almost $50 oil price we are experiencing.

It has therefore become near-dogma in energy policy circles to note that oil will remain much more expensive in the foreseeable future than it has been since the mid-1980s. The chant is: demand from emerging countries is soaring, with China in the lead, not to mention the oil-hungry US economy.

On the supply side, opportunities for international oil companies to replace reserves from ‘greenfield’, exploration-led projects, seem to be getting scarce.

Access to Russia’s brownfields (mainly through equity participation in Russian private companies), as well as to unconventional ultra-heavy oil in North America, and to development-led projects in OPEC countries, are critical to oil reserve replacement. As for OPEC, its member states lack either the will, or the capacity, or both, significantly to expand oil production capacities.

This new conventional wisdom is almost certain to be proven wrong, since it is really the irresistible temptation to see a new paradigm emerging behind the circumstances of the day.

When prices are high, people tend to think they will remain so. And the higher the prices the firmer the belief.

But economic laws seem to be hard to dispose of.

There are now many signs that the oil market may be on the verge of softening. The Chinese economy has already significantly cooled down as a result of able macroeconomic management by the country’s economic authorities.

Commercial oil stocks have been rebuilding world-wide from their lows of the last two years, and there may be more here that meets the eye as analysts see quite a lot of unreported stock building.

International oil companies are investing heavily in ‘upstream’ projects. A number of significant projects will be coming on stream between the Autumn of 2004 and the end of 2005 – from west Africa, the Gulf of Mexico, the Caspian, Latin America, Asia, and, yes, extra-heavy ‘non-conventional’ oil from North America.

Finally, almost every OPEC country, except perhaps Venezuela and, for obvious reasons, Iraq, is now investing in new production capacity – and so are the Gulf states: Iran, the United Arab Emirates, and Saudi Arabia are all engaged in capacity expansion. More than one million barrels per day of new OPEC capacity could come on stream this year, with more to come.

Of course, contingencies could overrule market fundamentals in the months to come; the most cited one, if not the most probable, is a big political crisis in Saudi Arabia.

This possibility may keep traders nervous and continue to drive speculators’ hopes. But eventually the fear premium will recede and one may discover, sometime in 2005, that the market is well oversupplied.

The oil market is very sensitive and the psychological factor is important: depending on anticipations, small changes in supply and demand can make a big difference in the price.

Given the real changes that are already visible, it may take only a small reassessment of anticipations to produce a significant price ‘correction’.

Dr Pierre Noël is a research fellow at Ifri, a Paris-based think-tank.